Tidy theories vs. messy reality

Michael Reich and Ken Jacobs have a recent NYT op-ed called All Economics Is Local, summarizing research on the impact of minimum wage increases on employment and prices. Suffice it to say, credible studies find no evidence of the catastrophic predictions frequently raised by some on the Right. I especially liked this part:

But how can minimum wage increases not have negative effects on employment? After all, according to basic economic theory, an increase in the price of labor should reduce employer demand for labor.

That’s not the whole story, though. A full analysis must include the variety of other ways labor costs might be absorbed, including savings from reduced worker turnover and improved efficiency, as well as higher prices and lower profits. Modern economics therefore regards the employment effect of a minimum-wage increase as a question that is not decided by theory, but by empirical testing.

Our research and that of other scholars illuminates how businesses actually absorb minimum wages at low-wage industries. Higher standards have an immediate effect in reducing employee turnover, leading to significant cost savings. Minimum wage increases do lead to small price increases, mainly in restaurants, which are intensive users of low-paid workers. How much? A 10 percent minimum wage increase adds 0.7 cents on the dollar to restaurant prices. Price increases in most other sectors, like retail, are too small to be visible, partly because retail pays more than restaurants.

That’s always my response: Okay fine, you took ECON 101 and basic principles of supply and demand lead you to predict a result. However, real social scientists test those predictions using empirical evidence. This is because there are a lot of other things in the world that aren’t part of the theory which may (or may not) keep things from working out that theory predicts. If a theory consistently provides poor predictions it’s time to get a better theory.

Some people have a strong aversion to the word theory. Call it what you will, we all think of the world in terms of a simplified version of how it works. We inevitably have to focus on some things at the expense of others. The point is to focus on the most important things for a given purpose and to ignore the ones that are less important.

The studies surveyed in the passage I quoted suggest that we shouldn’t think of employment economics just in terms of supply, demand, and prices of labor. Rather things like turnover can be important enough to change results. It’s almost as thought we’re dealing with human beings and not interchangeable commodities.